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Wednesday, 27 June 2012

What Germany wants?

Europe is once again on the edge of the cliff. They’ve been in this situation so many times since August last year that the entire story is becoming ridiculous. Spain is out of money to finance itself and its banks; Greece, even though the pro-bailout coalition was formed, remains Europe’s weakest point; Italy is in direct threat of a Spanish default (the situation was reversed 6 months ago, when Italy was the one who threatened to pull Spain along with it), and yet the blame again falls on Germany. Some economists even claim that Germany is being the biggest threat to the survival of the euro and that its forced austerity and unwillingness to step up and offer more bailouts and more support for the Union, are the main reasons behind Europe’s slow (and virtually non-existent) recovery.

Even among the Germans themselves, notable economists argue over whether or not Germany should offer more bailouts and consequentially bear more risk (I recommend an interesting debate on this issue, started after Prof. Hans-Werner Sinn, President of the Ifo Institute, University of Munich, wrote an op-ed in the NYT on “Why Germany is Balking on a Bailout”, to which Prof. Albrecht Ritschl of LSE replied on the Economist’s Free Exchange blog. The debate continued further - here and here. I encourage you to read it).

But Merkel stands strong against her critics, domestic and (particularly) foreign. In her latest speech she rejected any possibility of a Eurobond, and pointed out how there is no easy solution to the debt crisis (see here, here, and here).

While it is true that German exports grew rapidly sustaining its CA surplus during the past decade, the huge difference between Germany and the rest of Europe can hardly be explained by exports and benefits from the exchange rate. The difference was much more systemic. And it is these systemic and institutional differences that Germany is now trying to fix and close.

German structural reform

Even after the adjustment and convergence of East Germany, the most important long-run structural reform was rather recent. It started in 2003 under the name “Agenda 2010”, and its plan was to reform the business environment in Germany. Its main goal was to reforming the social security system in order to incentivise more people to work, not live off the welfare state (this included cutting the unemployment benefits, cutting income taxes, and cutting medical treatment benefits). It was also aimed at restoring businesses growth and reducing their regulatory burden. Surprisingly or not, it was initiated by a social democrat government, under the Chancellor Gerhard Schroeder.

“The centerpiece were labor-market reforms...The power of unions and craft guilds was curtailed, making it easier for unskilled youth to enter the job market and easier for employers to hire and fire at will. Germany's lavish unemployment benefits were sharply cut back. An unemployed person in social-democratic Germany today can draw benefits for only about half as long as his counterpart in capitalist America.

The immediate reaction was a brief rise in unemployment, as German business was allowed for the first time to optimize its labor force. And there was a backlash by powerful union and guild interests, costing Mr. Schroeder his bid for re-election. But Germany was transformed.”

The full effects of the reform weren’t visible until 2005 when unemployment started falling and businesses started growing. This is best shown in Germany’s business freedom index which went up by almost 20 points as a result of the reform:

Source: Heritage Index of Economic Freedom, Germany.Note: the black line represents the World average scores.

Naturally the measures were unpopular at first. They actually caused
Schroeder to lose the elections (in 2005 it was a grand coalition of the two biggest parties – SPD and CDU, with Merkel becoming the Chancellor. That already signalled the political end of Schroeder, with elections in 2009 only strengthening Merkel’s position, even though she still needed a coalition – this time, with the liberal FDP).

The ultimate cost of unpopular measures is very often an election loss to the governing party. But the situation in Europe now made voters prepared for a tough time and painful reforms. The interest groups who will be hit mostly by the reforms are resilient in their fight against them. And this is creating even more political pressure. But so far, all the governments in the periphery won the elections (or were appointed – Monti) in order to do the reforms. The democratic majority accepted that reforms are a must.

So what does Germany really want for Europe? It wants it to go through its own supply side revolution. Just like they did in the 90s and the 2000s, which created a basis upon which they built their export-led growth in the later part of the 2000s (see first graph here). They had to have something to export in order to exploit the favourable currency, didn’t they?

The bottom line is that Germany wants Europe to create its own supply-side revolution. That's why the current measures are necessary and that's why I strongly support Angela Merkel and her government. No one ever said it was going to be easy, but the periphery has postponed it long enough.

4 comments:

I am from Germany and the way we see it, Agenda 2010 did have some good effects, but in general it increased the inequality in Germany by almost a half since 2003, and it didn't have all that big of an impact on reducing unemployment. Why unemployment has decreased since the start of the crisis in 2009 has a lot to do with the German model of not letting people get fired and keeping them on the job, while only reducing their working hours. People were working in shifts which meant less money in temporary, but it made everyone feel safer about not losing their job. That was the most important thing why unemployment didn't go up and why it actually decreased by now. The Agenda wanted to make it easier to fire people but that doesn't make the economy better off. People need security and once they got it they didn't decrease their spending as they would have done if they lost their jobs.

I came across a lot of papers and research that goes beyond the reasons you mention in explaining why Germany's labour market didn't react to the crisis so severely. I remembered this text by Burda and Hunt on VoxEU from last year:

"the extraordinary performance of the German labour market in 2008–09 can most clearly be tied to a possibly one-off event with less favourable social welfare implications. In other words, firms had less need to lay off than in a typical recession, because an unusual lack of confidence in the preceding boom had made them reticent to hire."

and

"In addition, growing concerns about shortages of skilled labour could reflect increasing marginal costs of changing the extensive margin, which would also lead to a more sluggish, drawn-out reaction to expected future determinants of labour demand. At the same time, by 2009 there was evidence in the business press that firms were confident that the (export-driven) recession would be relatively brief."

Also, this paper sums things up pretty well: "We argue that important factors that have contributed to this development include the strong position of the German economy due to recent labor market reforms, the nature of the crisis affecting mainly export-oriented companies in Germany, the extension of short-time work, the behavior of social partners, and automatic stabilizers. Among these factors, we emphasize the key role of the interaction between shorttime work and long-term shortages of skilled workers in sectors and regions that were particularly affected by the crisis."

all these factors they explain are due to a cultural difference of the German Mittelstand model of firm clustering. These are small and medium sized businesses which collaborate together in innovation, manufacturing and are all export-oriented. It also gives workers a say in managing the company so it builds on different cultural and ethical values. This is why the owners didn't want to let the people go, they are all tied in together and that's why they succeed. The apprentices system was another important reason why German unemployment stayed low. Owners are more fond of having to train people in the workplace than to have a bunch of students with no use for their degrees. This solves the youth unemployment problem really well.

All this is undoubtedly true as the cultural differences you mention certainly made it easier to implement the reforms. However, just like in the Swedish case of a more favourable institutional and cultural environment, the structural reforms, not the system itself, made it more robust to exogenous shocks like the crisis.